Sequestration is more likely than you think

An F-35 Lightning II maneuvers during its first flight over Eglin Air Force Base, Fla., April 23, 2009.

Sequestration: it’s a term only Washington could love. Behind the bland euphemism lie dramatic cuts to the U.S. military, shipbuilding and aerospace manufacturing jobs, and in communities across America.

Washington politicians insist a half trillion in defense cuts — and the attendant degradation to our national security — is a reasoned belt tightening. In reality, sequestration is nothing more than seat of the pants management, a lurch from crisis to crisis. No reasoned, thoughtful process brought this on; it was simply the last minute debt ceiling deal. Now that the cuts are baked into the cake, President Obama has threatened to veto any efforts to unwind sequestration that do not include tax increases.

The president’s veto threat pushes any effort to seriously address these budget cuts to the lame duck session of Congress after the election in November. That does not mean everything will get fixed after the election. Removed from immediate electoral concerns, the thinking goes, Congress will be freed to act decisively, and the winning side in November will emerge with a clear mandate to avoid sequestration through their preferred method — the Democrats, by raising taxes and the Republicans, by cutting entitlements. But no side is likely to emerge with a clear mandate or large majority. All of the same fights and dug-in positions will still be the same after the election as they are today.

Worse still, sequestration is already having an impact.

Military’s Budget Is Hostage To a Much Larger Political Fight

The road to the erosion of our military capabilities and the jobs that support them (public and private sector) begins with political gridlock in Washington. House leadership is moving legislation to “fix” sequestration this month. But any House solutions are dead on arrival in the Senate. There, the Democratic majority believes that the threat of sequestration will force Republicans to accede to tax hikes, and Majority Leader Harry Reid has no intention of sacrificing that leverage to stave off additional defense cuts. As Senate Armed Services Committee Chairman Carl Levin stated:

“The dam has got to be broken on revenues and what will break it, I believe, is sequestration…And it can’t be divided and splintered up. It’s got to be kept intact. And that’s what I believe will move the rigid ideologues to deal finally with revenues.”

Reid concurred and backed up the White House veto threat:

“In the absence of a balanced plan that would reduce the deficit by at least [the $2 trillion in deficit reduction agreed to in August], I will oppose any efforts to change or roll back the sequester.”

The election is unlikely to change these dynamics. Worse yet, another less anticipated shock could disrupt the system. When the Standard and Poor’s downgraded America’s credit rating in 2011, the loss of the AAA rating was not the end of the game-it was the beginning. As S&P noted at the time:

“The outlook on the long-term rating is negative. We could lower the long-term rating to ‘AA’ within the next two years if we see that less reduction in spending than agreed to, higher interest rates, or new fiscal pressures during the period result in a higher general government debt trajectory than we currently assume in our base case.”

What this means, as BB&T Capital Markets analyst Jeremy W. Devaney notes, is that “delays or single year budget patches may be frowned upon by the ratings agencies under the premise that short-term fixes are displays of governance failures, poor policy, or weak fiscal discipline — all items of risk called out by the S&P.”

Since the only sequestration fixes currently under discussion are short-term, the ratings agencies are watching to see if they should consider another credit downgrade. That could cause a major financial upheaval, raise interest rates, and significantly disrupt the economy at the very time that Congress is trying to reverse defense cuts.

Sequestration and a potential credit downgrade are not the only matters of significance facing the lame duck Congress. A short list of items on the lame duck legislative agenda include:

Expiration of the Bush tax cuts,

Increasing the debt ceiling,

Expiration of the temporary payroll tax relief holiday,

Expiration of the annual “tax extenders” break,

Transportation and farm bill reauthorizations,

Medicare “Doc Fix,”

Fiscal 2013 appropriations bills, and

Sequestration.

Each of these items is a mini-war in and of itself; having to address them all at once means sequestration is unlikely to get much attention. In addition, the automatic military budget cuts have become a pawn in a larger negotiation about taxes and America’s overwhelming debt.

Even House Budget Committee Chairman Paul Ryan is skeptical of a grand bargain, saying he has a “hard time” believing that a mood of compromise will overtake Congress after the elections. Part of the challenge is that the ratings agencies’ calculation of the net present value of the future years’ debt reductions would require larger savings to be generated in the out years in order to meet the $1.2 trillion target in last year’s debt ceiling deal. Even if Congress were to agree on change, members would be forced to generate additional savings beyond the roughly $100 billion sequestered in fiscal 2013. This sets the bar even higher for compromise to repeal and replace the currently planned cuts.

Soft Sequestration Has Already Begun

Further complicating a workable solution and alternative to current law is a murky understanding of the mechanics of sequestration. The administration has argued that sequestration must be implemented at the “program, project, and activity” level, cutting all programs equally by about 10 percent. Potentially, this means that the funding for each and every line item in the military’s budget would be automatically reduced by 10 percent overnight. In some cases, the impact is manageable — the Air Force could buy nine drones instead of 10, for instance.

But with larger programs or military construction, sequestration means that some projects cannot even start. The Pentagon cannot buy nine-tenths of a ship or build half of a school. A plane can’t be built with half an assembly line. As a result, work is already being slowed for fear programs will never be finished.

Some argue that an amendment to the 1990 Defense Appropriations Act might allow the administration to reprogram funding between accounts before sequester — leading to “strategically” allocated cuts. This scenario could play out if the Congress ratifies a Joint Resolution giving the President the authority to implement cuts at his discretion while staying under the caps mandated by the Budget Control Act. Another potential option is interpreting the sequester as applying broadly to categories such as “Aircraft Procurement-Air Force” and targeting the cuts within these categories, leading to increased flexibility.

Perversely, however, the more flexibility that Pentagon leaders have to choose where they would cut, the more likely Congress is to assume that the cuts will not be catastrophic, and the more likely that sequestration in some form will stand.

Sequestration in All But Name Only

Even if Congress, against all odds, manages to strike a deal, the results will still greatly damage the military. The most likely scenario is that sequestration takes effect in all but name only, at a slightly lower amount and with some flexibility for the Pentagon to target cuts. At its full amount, sequestration would cut $99 billion from the fiscal 2013 defense budget, up from Budget Control Act cuts of roughly $50 billion reflected in the President’s budget request. This means that the probable final scenario is roughly $60 to $85 billion in defense cuts in 2013, leading to roughly $600 to $850 billion in cuts over the next nine years (as opposed to the full $1 trillion).

There are three likely scenarios when it comes to the final amount of defense cuts over the next decade. The new floor is the President’s budget request, which cuts $487 billion. Full sequestration would cut $1 trillion. The “split the baby” option outlined above would cut somewhere between $600 and $850 billion. Secretary Panetta has already outlined many of the possible program cutbacks, delays, and terminations that could take place under full sequestration. Just a few of these include the F-35, the next-generation bomber, the Littoral Combat Ship, delaying the SSBN (X) and permanently cutting the inventory of boats to 10, European Missile Defense, and eliminating the ICBM leg of the nuclear triad.

But how would the “Goldilocks” scenario of $600 to $850 billion in spending reductions impact the military? Because only a few systems comprise an overwhelming percentage of the Pentagon’s modernization budget, virtually all the same programs would still be harmed, delayed and possibly broken permanently as during full sequestration. The F-35, Littoral Combat ship, V-22 Osprey, the Maritime Prepositioning Force, Ballistic Missile Defense, the next-generation bomber, the SSBN (X) and one or two Carrier Strike Groups could all be canceled or delayed indefinitely. These cuts would the capacity of the military to meet all of its global obligations quickly, harm the services’ anemic modernization plans, lead to layoffs at depots, bases, and factories, and would effectively halt any strategic pivot to Asia.

Sequestration Has Begun

Although the lame duck scenario presupposes that sequestration can wait until January, sequestration starts now. In fact, the worst of sequestration will hit in the October to December timeframe, not in January, as the Pentagon and contractors start anticipating the major cuts. BB&T’s Devaney writes that DoD will change what it is buying in anticipation of sequestration resulting in lost revenue, lost jobs, and a depleted defense industrial base. In fact, the Pentagon will begin a “soft shutdown” in preparation for a “hard stop” of programs on January 2. This means that even if Congress passes a lame duck deal, it may already be too late for some furloughed people and programs.

In 2011, due to Congress’ refusal to pass a budget, all of the federal government, including the Department of Defense, operated under a series of continuing resolutions (CRs) that essentially locked in past spending levels one increment at a time until Congress finally passed a budget. In FY 2011, this process went on for six months and wrought havoc on the Pentagon’s budgeting process. Under the CR, many of the services couldn’t hire new employees, the Pentagon couldn’t initiate new construction projects, and the services couldn’t expand their purchases of existing programs.

This autumn will feature a sort of “soft sequestration” that will closely mirror the CR crisis of 2011 — only it will be much worse. DoD will not receive funds until the second half of this fiscal year, and once it has cash in hand, will not receive a full year’s dollars but rather periodic inflows of cash. As a result, major contract actions will be held in abeyance. Furthermore, many DoD program managers will delay soliciting bids for programs until they have cash on hand or the cloud of sequestration is lifted.

Both of these factors will create a massive bow wave in spending at the end of the year that the system may not be able to fully absorb, resulting in schedule slips and cost increases.These will, in turn, hurt the ramp for Pentagon programs, making them un-executable in the next fiscal year. The cost of the program will subsequently rise and increase the likelihood of further reductions or outright cancellation.

On top of all this is the reality that government and industry officials will make certain assumptions in the absence of action by Congress regarding what will ultimately be appropriated. The expected lower amount will drive decision-making as defense officials obligate the dollars they ultimately receive. For instance, many construction projects may be canceled outright when they might have simply been delayed in previous budgetary cycles. Finally, operating at reduced funding for a fraction of the fiscal year means personnel and O&M accounts will be short of dollars. The Pentagon will move money from other urgent priorities to cover the gaps in these “must pay” shortfalls, shortchanging other priorities like modernization.

Nor will the effects of soft sequestration be limited to the Pentagon. Just as DoD cannot wait until lame duck to begin layoffs in anticipation of sequestration, industry will begin looking at layoffs, as well. According to the WARN Act, industry is required to notify its employees of furlough 60 days prior to the action. As Lockheed Martin CEO Robert Stevens said,

“The very prospect of sequestration is already having a chilling effect on the industry. We’re not gonna hire, we’re not gonna make speculative investments, we’re not gonna invest in incremental training because the uncertainty associated with $53 billion of reductions in the first fiscal quarter of next year is a huge disruption to our business.”

Maybe the Mayans Were Right

December 2012 is shaping up to be a cataclysmic month. Outside of the halls of Congress, the world is facing a witch’s brew of challenges, including the European debt crisis, the continued development of the Iranian nuclear weapons program, and tensions involving North Korea that take us to “within an inch of war” daily according to Secretary Panetta. All of these factors combine with the American presidential elections, a possible debt downgrade, the specter of an economic shock from three tax cuts expiring simultaneously and an ongoing strategic pivot to Asia where a rising great power competitor regularly tries to undermine American power.

The world is becoming increasingly scary at the very time that the military will be facing 20% reductions. With each passing day, the world closes in; with each passing day, our ability to manage that world degrades.